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The Case Against Mergers


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THE CASE AGAINST MERGERS

American companies are in the grip of full-blown merger mania. In the first nine months of the year, according to Mergerstat, a merger research service, the value of all announced deals reached $248.5 billion, surpassing by a hairbreadth the record full-year volume of $246.9 billion for 1988. The number of transactions valued at more than $100 million will likely top the record 383 announced last year.

Leading the pack are banks, health-care providers, computer-software concerns and media, communications, and entertainment giants. Lately, consolidation in the utility and insurance industries has picked up steam.

BURDENS. This historic surge of consolidations and combinations is occurring in the face of strong evidence that mergers and acquisitions, at least over the past 35 years or so, have hurt more than helped companies and shareholders. The conglomerate deals of the 1960s and 1970s that gave rise to such unwieldy companies as ITT Corp. and Litton Industries have since been thoroughly discredited, and most of these behemoths have been broken up.

The debt-laden leveraged buyouts and bust-ups of the 1980s didn't fare any better, and many surely did a whole lot worse. That era ended not with a whimper but with a bang: In October, 1989, when bankers couldn't raise the money for the ill-conceived buyout of UAL Corp., the deal collapsed, dragging the stock market down with it.

But by the 1990s, chief executives and investment bankers figured that they had finally gotten it right. If UAL marked the end of the 1980s crazy season, then the July, 1991, announcement by Chemical Bank Corp. and Manufacturers Hanover Corp. that they would join in a $2.3 billion stock swap to create the nation's second-largest banking company and produce $650 million in annual expense savings by 1994, seemed to signal that the Age of Reason in mergers and acquisitions had begun. This was to be the era of strategic deals--friendly, intelligent, and relatively debt-free transactions done mostly as stock swaps, which were supposed to enrich shareholders by producing synergies in which two plus two would equal five or more. These synergies would take the form of economies of scale, improved channels of distribution, greater market clout, and ultimately higher profits for surviving companies. Although Harvard University's Michael Porter in a seminal May, 1987, Harvard Business Review article argued persuasively that most would-be deal synergies are never realized, the new strategic transactions, Wall Street promised, would be different.

It turns out they're not. Indeed, with investment bankers singing their new, improved siren song, many big company CEOs are demonstrating that they still are as vulnerable to the latest fad as the most naive individual investor.

OFF THE MARK. An exhaustive analysis by BUSINESS WEEK and Mercer Management Consulting Inc., a leading management consulting firm, of hundreds of deals completed in the first half of this decade indicates that their performance has fallen far short of their promise. Deals that were announced with much fanfare such as AT&T's 1991 acquisition of NCR and Matsushita's 1991 acquisition of MCA, have since unraveled. Others, including KeyCorp's 1994 merger with Cleveland's Society National Bank, acquisitions by big pharmaceutical manufacturers of drug wholesalers, as well as software and entertainment deals aren't producing the results the acquirers had hoped for--nor are they likely to produce good results in the future.

The anecdotal findings are supported statistically. The BUSINESS WEEK/Mercer analysis indicates that companies performed better in the wake of '90s deals, most of which have been done ostensibly for business reasons, than they did after '80s transactions, a high proportion of which were financially driven. But the analysis also concluded that most of the '90s deals still haven't worked. Of 150 recent deals valued at $500 million or more, about half destroyed shareholder wealth, judged by stock performance in relation to Standard & Poor's industry indexes. Another third contributed only marginally to it. Further, says James Quella, director of Mercer Management Consulting, "many deals destroy a lot of value." Mergers and acquisitions, he declares, "are still a slippery slope."

Using a large sample and comparing total return three months before the merger announcements with returns up to 36 months afterward, the analysis used the S&P industry indexes to filter out, as much as possible, other external events affecting acquirers' returns. Though the data obtained with the Mercer methodology, which has been used by many students of M&A performance, are not perfect, they are considered a good proxy for the impact of mergers on buyer returns.

Deal performance has been poor because melding two companies is enormously difficult and only a few companies are very good at it. One reason is that buyers often stack the odds against success by rushing headlong into mergers and acquisitions for the wrong reasons in search of synergies that don't exist. To make matters worse, they often pay outlandish premiums that can't be recovered even if everything goes right. And finally--and this is the real deal-killer--they fail to effectively integrate the two companies after the toasts have been exchanged. Good postmerger integration rarely makes a really bad deal work, but bad execution almost always wrecks one that might have had a shot. Says Kenneth W. Smith, a Mercer vice-president based in Toronto: "The deal is won or lost after it's done."

EXPECTATIONS. While it's too early to pass final judgment, some recently announced but not-yet-completed megadeals seem iffy as well. The planned takeover of Turner Broadcasting by Time Warner, itself a value-destroying combination, and Disney's proposed acquisition of Capital Cities/ABC leave many media-industry observers scratching their heads over where the gains are going to come from. "For all these deals to work out, you have to believe that the American public is underentertained," says Wilbur L. Ross, senior managing director at Rothschild Inc.

In other key findings, the analysis indicated that:

-- Most transactions fall below expectations, but an even greater percentage of companies lose in the M&A game. That's because a few large, proficient acquirers, such as General Electric Co. and Dover Corp. (BW--Jan. 23), tend to do a lot of successful deals while a much larger number of less adept companies execute one or two unsuccessful mergers. In the 5 1/2 years ending July 31, 72% of companies that completed six or more deals valued over $5 million each yielded returns above the industry average, compared with 54% of companies that closed just one to five transactions.

-- Nonacquirers are more likely to outperform their respective industry indices than are active acquirers (page 136). Only about a third of the nation's 500 largest companies have not yet made a single acquisition larger than $5 million so far this decade. But from Jan. 1, 1990, through July 31, 1995, 69% of companies that made no acquisitions larger than $5 million outperformed their respective Standard & Poor's industry indices. Only 58% of all acquirers did better than their industry indices. Many companies--notably Andrew Corp. and Coca Cola Co.--whose industry rivals are bent on growing through acquisition, have delivered superior returns by keeping investment bankers at bay and sticking to their knitting.

SUCCESSES. To be sure, some strategic transactions, such as the Chemical-Manny Hanny merger and Primerica's October, 1993, acquisition of Travelers Corp., have lived up to expectations. Toymaker Mattel Corp.'s $1.15 billion acquisition in 1993 of Fisher-Price has worked out well. And analysts say that while the $1.12 billion that Campbell Soup paid in February, 1995, for Pace Foods was steep, the deal will likely pan out. But the kinds of mergers and acquisitions with a better-than-even shot at success are limited indeed. Small and midsize deals--notably leveraged "buildups" in such fragmented industries as funeral homes and health clubs--frequently work. The best acquisitions, says Harvard's Porter, involve "gap-filling," including those in which one company buys another to strengthen its product line or expand its territory. "Globalizing" acquisitions, such as those that enable companies to expand their core business into other countries, may make sense, though culture and language problems undermine many of these deals (page 132). Mergers of direct competitors aimed at dominating a market, such as marriages of big banks with overlapping branches, often have worked out.

Failures, though, outweigh the successes. Many deals are poorly thought out, founded on dubious assumptions about the potential benefits by CEOs with questionable motivations.

Some academics lately have even tried to quantify what many have long sensed intuitively: that some of the priciest deals are motivated at least in part by CEO hubris. A recent Columbia University business school study suggested that the bigger the ego of the acquiring company's CEO--as reflected in such things as relative compensation and media praise--the higher the premium the company is likely to pay. Although some have questioned the methodology, many agree with the conclusions.

"There's tremendous allure to mergers and acquisitions," says Porter. "It's the big play, the dramatic gesture. With the stroke of a pen you can add billions to size, get a front-page story, and create excitement in the markets."

Other emotions also play a role. First Chicago Corp.'s Richard L. Thomas may not have been driven by personal hubris as much as by civic pride. Some contend he rushed into merging with NBD Bancorp, parent of National Bank of Detroit, in July out of fear of being bought out by voracious NationsBank. "His goal was to keep a Chicago bank in Chicago," says one bank insider.

GOOD MONEY. Optimism is bolstered by a variety of rationales. One is that vertical integration--linking manufacturing with distribution--will yield vast synergies. On that theory, Merck, Eli Lilly, and SmithKline paid handsomely for drug wholesalers, but the prospects for those deals are looking bleaker and bleaker (page 124). Such linkages are behind the Hollywood deals, such as Disney's acquisition of Capital Cities/ABC. "I hate to use the `s' word," says Disney Chairman Michael Eisner, "but that's synergy at work." Others are skeptical. Says Tele-Communications Inc. CEO John C. Malone: "It's an industry that's as certain as betting on a race horse."

Numerous companies have blundered lately when they tried to engineer a major redefinition of their businesses through merger and acquisition--often in response to sea changes in regulation, technology, and even geopolitics. If the spate of copycat deals in computers, telecommunications, media, and technology are any indication, these companies seem to fear they will be left behind forever if they don't do something and do it fast. "Nobody wants to be marooned," says David A. Nadler, chairman of Delta Consulting Group.

In 1991, when AT&T succeeded in taking over computer maker NCR, it figured it had won a major victory in its dream of linking computers and telecommunications. As things turned out, the dream proved to be wishful thinking. Moreover, sources familiar with the marriage say that AT&T may have erred by taking a hands-off approach. Ironically, when NCR later acquired Teradata Corp., it blew away some of the company's most creative people.

Harsco Corp., a diversified manufacturer based in Harrisburg, Pa. succeeded in expanding its steel mill service business globally with its $400 million acquisition of MultiServe International. But it still stumbled in trying to turn swords into plowshares with a tiny deal. When Harsco lost its U. S. Army contract to supply five-ton trucks, it paid $2 million to a defunct school-bus company in a bid to salvage the truck plant, which was now making trucks for export. "The startup period was too slow, production costs were too high, and Harsco failed to gain market penetration," says Harsco Chairman Derek C. Hathaway. Meanwhile, foreign truck deals fell through. In 1994, Harsco moved to close the plant and charged off $8 million.

Although consolidation of health-care providers has made sense for some, it certainly didn't for Dallas-based Medical Care International Inc. and Critical Care America, based in Westborough, Mass. If ever there was a marriage made in hell, this September, 1992, combination of the nation's largest surgery-center chain and largest independent operator of home intravenous services was it. The concept--to create a hospital without walls and enable Medical Care America to profit from the rising demand for low-cost outpatient services--certainly sounded good. But virtually everything that could go wrong in a merger went wrong in this one. Poor timing, faulty due diligence, culture clashes, and big egos doomed the deal from the start. The merger took place just as intensified competition began driving down prices for home infusion services. Critical Care's problems were masked by slow insurer payments and infrequent internal reporting, which made it difficult to spot trends.

Less than three weeks after the merger, Chairman and CEO Donald E. Steen announced that third-quarter 1992 results would fall below expectations, triggering a free fall in Medical Care America's shares. Management responded by slashing Critical Care's staff, which, in turn, caused it to lose customers. Shareholder lawsuits followed. "The Critical Care merger was bad, really bad," says Steen. "It's something I'm trying to forget." In March, 1994, Medical Care America sold off Critical Care to Caremark International Inc. and six months later sold out to Columbia/HCA Healthcare Corp. for $850 million. "This has been a very good merger," Steen says, largely because its broad geographic coverage and supply contracts have enabled it to lower prices.

CHAPTER 11. Other attempts at expanding by acquiring closely related companies have also bombed. Take, for example, Kmart Corp.'s early 1990s acquisitions strategy. Instead of focusing on its core discount business, it lost more ground to Wal-Mart Stores Inc. when it diverted its attention and capital to buying up fast-growing specialized retailers, sometimes paying top dollar. By yearend 1992, Kmart had become a $30 billion-sales retail conglomerate with seven specialty store chains and 2,300 Kmart stores. But overhead was higher than rival Wal-Mart and sales per square foot lower. "The Kmart stores were totally neglected," says Trish Reopelle, an analyst with the State of Wisconsin Investment Board. A year later, Kmart was forced to begin selling its specialty stores and by 1995, CEO Joseph Antonini was out of a job. Lately, analysts have even suggested that Kmart file for bankruptcy protection. The company denied it had such intentions.

After failing to come up with a workable strategic rationale, buyers too frequently are seduced into overpaying. Mark Sirower, an assistant professor of management at New York University's Stern School of Business, author of a 1994 doctoral dissertation on the link between acquisition premium and synergy, says: "If you're paying a high premium for an opportunistic acquisition, you ought to know [that] on average, it's not going to work. It's not going to earn back its cost of capital."

What's an excessive acquisition premium? Says Sirower: "Because synergies are so difficult to achieve even with a sound strategy, once you cross the 25% threshold, you're really piling on the risk." If Sirower is right, then a lot of companies are gambling heavily. So far in 1995, according to Mergerstat, average premiums on deals over $500 million was about 37%, down from about 41% last year but up dramatically from 26% in 1993.

Companies, Sirower says, already are forced to compete so hard that it's difficult to produce large gains in returns and profitability. "But if you pay a premium, you've got to compete even better." Meanwhile, he says, "the clock is ticking on the extra money you've paid." In his dissertation, Sirower concluded that to recover, say, a 50% acquisition premium, a buyer who began realizing synergies in the second year would have to, in effect, increase the return on equity of the target by 12 percentage points in the second year and maintain it over the next nine years--just to break even.

That makes Time Warner Inc.'s $7.5 billion offer for Turner Broadcasting System Inc. appear even more bizarre. Says Mercer's Quella: "Turner overpaid for much of what he bought, and now Time Warner is paying a premium on top of that."

Although buyers think they may be doing the smart thing by buying a company in a related business, the Mercer analysis found that because they pay higher premiums than they do for companies in unrelated businesses, they leave the advantages of related acquisitions on the negotiating table.

But most experts say that the deal-breaker is usually bad postmerger planning and integration. They generally agree that if a deal is to stand any chance of success, companies must move quickly and decisively to appoint the new management team, cut costs, reassure customers, and resolve cultural conflicts.

First Chicago's planned merger with NBD has some insiders wondering whether these two disparate corporate cultures--a freewheeling money center institution that serves large corporations, and NBD, a conservative middle-market lender--can possibly work together. Four months into the merger, insiders say lines of management responsibility and authority are still unclear. Said one senior executive: "The people in Chicago think they are being taken over by Detroit, and the people in Detroit think they are being taken over by Chicago."

Few deals made more sense on paper yet so little sense culturally than the October, 1993, merger of Price Club and Costco Wholesale to create Price/Costco Inc., which became the second-largest operator of warehouse clubs after Wal-Mart's Sam's Club. "The economies of the two companies coming together to compete with Sam's Club were compelling," says Jeffrey Atkin, principal of the Seattle money-management firm of Kunath Karren Rinne & Atkin.

The deal had many problems, but the worst were cultural. The Price and Costco people just didn't seem to hit it off. Says analyst Michael J. Shea of Charter Investment Group: "The Price guys had much more of a real estate strip-mall mentality. The Costco guys were the type who started working at grocery stores bagging groceries when they were 10 years old and worked their way up the ladder." In one of the shortest corporate marriages ever, Price and Costco broke up after less than a year, in August, 1994. Says analyst Mark Byl, of Laird Norton Trust Co.: "The best thing to happen to that marriage was the divorce."

All this indicates that many large-company CEOs are making multibillion-dollar decisions about the future of their companies, employees, and shareholders in part by the seat of their pants. When things go wrong, as the evidence demonstrates that they often do, these decisions create unnecessary tumult, losses, and heartache. While there clearly is a role for thoughtful and well-conceived mergers in American business, all too many don't meet that description. Moreover, in merging and acquiring mindlessly and flamboyantly, dealmakers may be eroding the nation's growth prospects and global competitiveness. Dollars that are wasted needlessly on mergers that don't work might better be spent on research and new-product development. And in view of the growing number of corporate divorces, it's clear that the best strategy for most would-be marriage partners is never to march to the altar at all.

Why Mergers Don't Work

-- Inadequate due diligence by acquirer or merger partner

-- Lack of a compelling strategic rationale

-- Unrealistic expectations of possible synergies

-- Paying too much

-- Conflicting corporate cultures

-- Failure to move quickly to meld the two companiesBy Phillip L. Zweig in New York, with Judy Perlman Kline in Pittsburgh, Stephanie Anderson Forest in Dallas, and Kevin Gudridge in Seattle


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